In a wide-ranging conversation, Cœuré reflects on the challenge of creating a truly pan-European and cross-border capital market in the region and how securitization can be used to re-establish funding to SME firms.
The recent focus of both regulation and markets has turned towards SMEs and the problems they face. There is recognition of the importance of getting financing to these firms to stimulate economic growth. In the US there is a huge and developed non-bank financing market for these companies. In Europe there is a long-term goal of shifting this financing away from the banks – how can that be achieved?
This is a really important issue right now, because SMEs are key to growth and they have a prominent role to play in kick-starting economic recovery in the region. In Europe, SMEs have traditionally relied on bank financing. This channel is currently impaired, not least because of the significant but necessary deleveraging that is going on in the European banking sector, but also because of the market fragmentation. Therefore it feeds into a more general project, namely recreating an integrated capital market in the euro area. This is something that warrants us all joining forces. The issue of financing SMEs throws into relief the difficulties and challenges that we face when we try to restart financing channels in the region. Right across the euro area, capital markets have been considerably impaired by the crisis and substantially fragmented. However, this has been receding since the summer of 2012 and we have seen many signs of improvemsuent in this respect. As a rough measure of euro area capital market fragmentation, Target2 balances have shrunk by some €300 billion and now stand at more than 25% below their peak level of July 2012.
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| Benoit Coeure, executive board member of the European Central Bank (ECB) |
To what extent is this a product of quantitative easing rather than improved fundamentals?
I would put it more positively: it is a sign of an on-going process of reform and convergence in the euro area economy. The structural adjustment and convergence between euro area economies that we have seen has also been reflected in financial markets in terms of both prices and quantity. To some extent, we have already seen a resumption of cross-border flows within the euro area. It is certainly not enough, but at least it is moving in the right direction.
In addition to the negative impact of the financial crisis, capital markets have been impaired in particular as a result of the link between banks and sovereigns. This adds a very local dimension to the crisis, which wasn’t really foreseen before it erupted. Today, it has morphed into a series of local crises in Europe, and we are still struggling to move out of that situation in the capital market. At the same time, the European banking system is still in the process of deleveraging and is to some extent encumbered with non-profitable loans. I won’t call them non-performing loans, because these loans are not necessarily toxic in any sense – they are just not making any money because the risk and return environment has changed. But as a consequence many euro area banks don’t have much room on their balance sheets to expand lending.
As we emerge from the crisis, I think we have to focus on two main challenges. First, we need to diversify the funding of the euro area economy and euro area corporates to make them less dependent on bank funding. At present bank financing represents two-thirds or maybe 70% to 80% of corporate financing, which is a very different situation to that in the United States. I don’t think that we should adopt the US model lock stock and barrel, because Europe is not the United States; it will always be different. Nevertheless, the crisis laid bare the fragility of a funding model that is exclusively dependent on banks. And when this funding became unavailable, the SME sector was hit hardest – large corporates in the euro area have been able to diversify and tap the corporate bond markets with a great deal of success, although this hasn’t been the case for smaller companies. To remedy this, we need to find ways to diversify, deepen and reintegrate capital markets in Europe.
The second challenge is how to create a truly pan-European and truly cross-border capital market in the euro area? For that to happen, all the actors have to join forces. Certainly, within its mandate, the ECB has a role to play by finding ways to reduce fragmentation and by improving monetary policy transmission. But there is a regulatory dimension too. When the regulators decide on the parameters and modalities of new regulation, this should not contradict the overarching objective to reintegrate European capital markets. Of course, market participants also have a role to play – this is not going to be driven by governments or by public actors alone. But this integrated market has to be profitable: participants are not going to be conjured out of thin air and supported by public money – that simply wouldn’t work.
Within this overarching aim to reintegrate capital markets, the SME sector is almost the hardest sector in which this can be achieved. SME financing is a domestic, local function that is tackled on a local level. It is a market that is almost by definition not integrated. So, is there a way to have pan-European SME financing?
We have to be pragmatic, of course. We need a mixture of local and regional initiatives. In particular, local actors, such as national and development banks, have an important role to play. The likes of KfW, Cassa Depositi e Prestiti and Banque publique d’investissement will remain very important actors when it comes to financing SMEs.
We also need to find ways of harnessing the full potential of the European capital market. SME financing will remain mainly national, it will remain local, but there are ways of reducing the national component of SME risk, or the component of the SME risk premium that is linked to national considerations. This has to do, in particular, with unequal economic conditions and convergence within the euro area.
The solution is first, to foster convergence and reform in the member countries, so that economic risk is spread more equally across the euro area. This relates to economic reform more generally.
Second, banking union has a key role to play. One of the reasons for the very diverse and dispersed cost of funding across the euro area is that it depends on where banks are located. This will come to an end once we have the single supervisory mechanism in place and when we have the single resolution mechanism too.
Third, the perception of risk remains very different across countries today, in particular in the so-called peripheral countries, or stressed countries, which have been hit more severely by the crisis. The rating of the sovereign impacts on the ratings and interest rates of financial products in these countries, and constitutes a hurdle to the development of markets for SME lending. Here, there has to be an element of cross-border risk sharing to help restart such markets in those constituencies where the sovereign has been most hit by the crisis. This legitimates the intervention of, say, the European Investment Bank, as a way of providing European support in stressed jurisdictions.
So would you say that addressing this issue on a pan-European basis can only happen when banking union is in place?
Actually, I would put it the other way around: banking union will be very helpful in reducing the dispersion of funding rates across the euro area, because it will help to overcome the current ring-fencing of capital and liquidity at national level. But this does not preclude starting to address other challenges. There are also technical ways of encouraging cross-border lending, including SME financing. Asset-backed securities are an example of this, which is why the ABS market is receiving so much attention at the moment. It gives a capital market dimension to the funding of SMEs and makes SMEs less exclusively reliant on local banks.
SME ABS has a chequered history, but this type of financing is what this technology is for, this is what it can do. Does this signify a softening of stance towards ABS? A recognition that the benefits of the technique are more important than demonizing it for what was done in the past?
First, just because financial innovation failed and led to the crisis does not mean that we should condemn it altogether. One of the biggest challenges in the post-crisis era is how to shape financial innovation in a way that is useful and in a way that does not create financial instability. This can be done with ABSs, just as it can be done in other market segments. Securitization can play a very useful role in redistributing risks and making it possible for risk to be borne by those actors with the capacity to bear it. Securitization offers benefits, but it has to be structured differently to how it was before the crisis.
It has to be simple – for example, we need to dispense with the multiple layers that we had before the crisis, such as CDO-squared and similar instruments. We need single-layer structures and we need transparency on what is in the underlying pool. Initiatives such as the ABS Loan-Level initiative, which the ECB has sponsored and now takes into account in its collateral requirements, or the Prime Collateralised Securities initiative are rebuilding confidence in this market, provided that the products remain simple and transparent. However, the ABS market will only be revived if the regulatory framework is supportive of simple and transparent forms of Securitization.
With regard to SME loans, would it not be the case that with an unguaranteed structure the overcollateralization that would be required would be so large that it would not be economic?
Ultimately, the market will answer this question. I completely agree that for the market to be sustainable, the economics of the product have to make sense. The current pricing environment and risk configuration are challenging, but there are ways of mitigating risks, with over-collateralisation being just one of them.
Such as getting someone to take the first loss piece?
Exactly. In the first instance, it can be bought by those investors that have the appetite for risk or the capacity for it. And there is a market for this – some investors are striving for higher yields! Provided that they have the ability to monitor risk and to cushion the possible losses, this does not pose a problem. It is the way a market should function. If there aren’t enough of these investors around, part of the risks can be taken by public institutions within their mandate. Here I don’t want to be too prescriptive, because the ECB is not among those institutions – I am referring to the national development banks, to the EIB, to the European Commission. These institutions have a mandate to take this kind of risks and have allocated capital to that end. Acting within their own governance mandates, they can play a very useful role in helping to kick-start the market.
Moving away from taking bank loans and securitizing them to non-banks doing the lending the first place. Lots of alternative lenders are anticipating taking substantial amounts of SME lending away from the banks. Are there any concerns about small companies starting to borrow from unregulated funds rather than banks, which have a role in society? And how much of the market can these funds really take?
If I wanted to be ironic, I would say that given what we have seen since 2007, there is no evidence to suggest that banks have played their role in society particularly well! But yes, banks have a special role to play in the economy; in the past they did play that role in Europe and they are very much expected to continue doing so. The role of bank lending is prominent and will remain prominent. Banks need to act as long-term partners to companies, but for a variety of reasons they are not able to play this role as well as we might expect them to. I am not casting the blame on banks here: this is because of the changing regulatory environment, because their balance sheets are still too big and because the economy is very risky.
They are currently not in a position to act as long-term partners to SMEs, so capital markets and non-bank investors are a useful complement. The latter are useful in the same way as a spare tyre, and even more than that, since, as I said, the financing mix of European companies will shift and become less dependent on bank funding. Of course it has to happen in a way that does not make the system unstable, whereby those that invest in SMEs, or in companies more generally, have a sense of a long-term relationship with the company that they are investing in. This is more challenging for non-banks, because this is not the way they operate. Yet, having this sense of commitment to the economic purpose that the companies are serving is crucial.
Is there a way that that can be established by external forces or does it rely on a change in mindset?
Probably, we need to foster a change in mind-set. This would be in the best interests of non-banks, because unless they monitor a project over a period of time and take ownership, they risk losing money. Of course, it has to be carefully monitored. For instance, the Financial Stability Board has a work stream on shadow banking, which looks among other things at the role of non-banks in financing the economy. Also the European Commission has initiated a broad debate on the future of financial intermediation in Europe with its Green Paper on the long-term financing of the European economy, which is now open to consultation.
The official community, the regulators and supervisors, need to follow this trend very carefully to ensure that we are not creating sources of risk elsewhere. Or to put it another way, to make sure that risk migrates to actors that have the capacity to bear it rather than to those that don’t understand it.
The retail bond market has been developed in several jurisdictions. As you say, risk needs to migrate to those that are capable of taking it – is that a retail investor? How do you monitor this development to make sure that the unsophisticated investors don’t get hurt?
For me, the answer is relatively straightforward: there have to be stricter requirements in terms of disclosure and of risk management for products that become retail products. This is enshrined in European law such as Mifid and the Prospectus Directive, and it is the role of regulators to check this. In order for it to work, these requirements must be very strict, but this does not mean that it should not be done.
Can you achieve what you are describing in terms of re-stimulating cross border lending without big changes to proposed Basle III and Solvency II regulation?
In terms of a general principle, I do not see a trade-off between strict financial regulation and economic purposes. We need both. We have to protect the purpose of financial regulation, which is to provide the right incentives to banks and other financial institutions and to ensure financial stability. I wouldn’t accept weaker financial regulation for the sake of lending to SMEs. There are, however, cases where we can improve on both, or where we can help to restart the market without compromising on financial stability.
We need to look very carefully into the tiny details of all these new regulations and, whenever possible, calibrate them in a way that is not harmful to lending. This is true for banking regulation as well as for insurance regulation. The Basle III framework for securitization is a case in point: it should penalise opacity and excessive risk-taking, but also acknowledge efforts made to create products that are safer and more transparent.
